Just before Christmas, news reports surfaced that President Trump was discussing how to go about firing Jerome Powell, Chairman of the Federal Reserve, ten months after having him appointed to the post. The purported reason: Mr. Trump was blaming stock market turbulence–not on his tax bill, which failed to reform the system and increased the government deficit, nor on the negative effect of his tariffs–but on Mr. Powell’s continuing to gradually raise short-term interest rates from their financial crisis lows back toward normal.

Ironically, the S&P 500 plunged by about 10%, making what I think will be seen as an important low, as the president’s deliberations became public.

why this is scary

The highest-level economic aim of the US is maximum sustainable GDP growth, with low inflation. In today’s world, the burden of achieving this falls almost entirely on the Fed (even I realize I write this too much, but: the rest of Washington is dysfunctional). The unwritten agreement within government is that the Fed will do things that are economically necessary but not politically popular, accepting associated blame, and the rest of Washington will leave it alone.

Mr. Trump seems, despite his Wharton diploma, not to have gotten the memo. This despite the likelihood that his strange mix of crony-oriented tax cuts and trade protection has made so few negative ripples in financial markets because participants believe the Fed will act as an economic stabilizer.

What happens, though, if the Fed is politicized in the way Mr. Trump appears to want?

The straightforward US example is the 1970s, when the Fed succumbed to Nixonian pressure for a too-easy monetary policy. That resulted in runaway inflation and a plunging currency. By 1978, foreigners were requiring that Treasury bonds be denominated in German marks or Swiss francs rather than dollars before they would purchase. The Fed Funds rate rose 20% in 1981 as the monetary authority struggled to get inflation under control.

The point is the negative effects are very bad and happen surprisingly quickly. This is more problematic for the US than for, say, Japan because about half the Treasuries in public hands are owned by foreigners, for who currency effects are immediately apparent.

I’m not a big fan of Lawrence Summers, but he had an interesting op-ed article in the Financial Times early this month. He observes that, unnoticed by most domestic stock market commentators, the foreign- exchange value of the dollar has steadily deteriorated since Mr. Trump’s inauguration. Currency futures markets are predicting a continuing deterioration in the coming years. He thinks the two things are connected. I do, too.

To my mind, what is happening on Wall Street recently is that currency market worry is now seeping into stock trading as well. If someone forced me to pick a catalyst for this move (I would prefer not to), I’d say it was the possibility, introduced in the press investigation of Cambridge Analytica, that what we’ve believed to be Mr. Trump’s uncanny insight into human motivation (arguably his principal redeeming feature) may be nothing more than his reading a script CA has prepared for him. This would echo the contrast between the role of successful businessman he played on reality TV vs. his sub-par real-world record (half the return of his fellow real estate investors while assuming twice the risk).

The real economic issue is not Mr. Trump’s flawed self, though. Rather, it’s the idea that public policy in Washington generally, White House and Congress, seems to have shifted from laissez faire promotion of businesses of the future to the opposite extreme–protecting sunset industries at the former’s expense. In this scenario, overall growth slows, and the country doubles down on areas of declining economic relevance.

We’ve seen this movie before–in the conduct of Tokyo, protecting the 1980s-era businesses of the descendants of the samurai while discouraging innovation. The result has been over a quarter-century of economic stagnation + a collapse in the currency.

Yesterday Venezuela began pre-sales of its petrocurrency, called the petro. The idea is that each token the government creates will be freely exchangeable into Venezuelan bolivars at the previous day’s price of a barrel of a specified Venezuelan crude oil produced by the national oil company. According to the Washington Post, $735 million worth of the tokens were sold on the first day.

uses?

For people with money trapped inside Venezuela, the petro may have some utility, since it will be accepted by Caracas for any official payments. For such potential users, the fact that the government determines the dollar/bolivar exchange rate and that a discount to the crude price will be applied are niggling worries.

perils

The wider issue, which remains unaddressed in this case, is that the spirit behind cryptocurrencies is a deep distrust of government, a strong belief that practically no ruling body will do the right thing to protect the fiscal well-being of users of its currency.

In Venezuela’s case, just look at the bolivar. The official exchange rate says $US1 = B10. But the actual rate, as far as I can tell, has fallen from that level over the past year or so to $US1 = B25000.

a little history

The more serious worry is that the history of commodity-backed currencies isn’t pretty.

Mexico

In the 1980s, for example a struggling Mexican government issued petrobonds. The idea was that at maturity the holder could choose to receive either $1000 or the value of a specified number of barrels of Mexican state-produced crude. Unfortunately for holders, Mexico reneged on the oil-price link. My recollection (this happened pre-internet so I can’t find confirmation online) is the Mexico also declined to make the return of principal on time.

the US

The fate of gold-backed securities around the world during the 1930s isn’t so hot, either. The US, for example, massively devalued (through depreciation of the gold exchange rate) the gold-backed currency it issued. It also basically banned the private ownership of physical gold and forced holders to turn in the lion’s share of their holdings to Washington in return for paper currency.

In short, when the going gets tough, there’s a big risk that the terms of any government-backed financial instrument get drastically rewritten. This recasting can come silently through inflation. But, if history holds true, government backing of a commodity link to financial instruments gives more the illusion of protection than the reality–especially so in cases where the reality is needed.

From the surprise election of Donald Trump as president through late December 2016, the S&P 500 rose by 7.3%. What was, to my mind, much more impressive, though less remarked on, was the 14% gain of the US$ vs the ¥ over that period and its 7% rise against the €.

the aftermath

Since the beginning of 2017, the S&P 500 has tacked on another +4.9%. However, as the charts on my Keeping Score page show, Trump-related sectors (Materials, Industrials, Financials, Energy) have lagged badly. The dollar has reversed course as well, losing about half its late-2016 gains against both the yen and euro.

How so?

Where to from here?

the S&P

The happy picture of late 2016 was that having one party control both Congress and the administration, and with a maverick president unwilling to tolerate government dysfunction, gridlock in Washington would end. Tax reform and infrastructure spending would top the agenda.

The reality so far, however, is that discord within the Republican Party plus the President’s surprisingly limited grasp of the relevant economic and political issues have resulted in continuing inaction. The latest pothole is Mr. Trump’s refusal to release his tax returns–that would reveal what he personally has to gain from the tax changes he is proposing.

On the other hand, disappointment about the potential for US profit advances generated by constructive fiscal policy has been offset by surprisingly strong growth indications from Continental Europe and, to a lesser extent, from China.

This is why equity investors in the US have shifted their interest away from Trump stocks and toward multinationals, world-leading tech stocks and beneficiaries of demographic change.

the dollar

The case for dollar strength has been based on the idea that new fiscal stimulus emanating from Washington would allow the Fed to raise interest rates at a faster clip this year than previously anticipated. Washington’s continuing ineptness, however, is giving fixed income and currency investors second thoughts. Hence, the dollar’s reversal of form.

tactics

Absent a reversal of form in Washington that permits substantial corporate tax reform, it’s hard for me to argue that the S&P is going up. Yes, we probably get some support from a slower interest rate increase program by the Fed, as well as from continuing grass-roots political action that threatens recalcitrant legislators with replacement in the next election. The dollar probably slides a bit, as well–a plus for the 50% or so of S&P earnings sourced abroad. But sideways is both the most likely and the best I think ws can hope for. Secular growth themes probably continue to predominate, with beneficiaries of fiscal stimulation lagging.

Having written that, I still think shale oil is interesting …and the contrarian in me says that at some point there will be a valuation case for things like shipping and basic materials. On the latter, I don’t think there’s any need to do more than nibble right now, though.

To a great degree, changes in interest rates and changes in currency substitute for each other in an overall macroeconomic sense. A rise in the world value of the US$ is equivalent to an increase in interest rates, in that both act to slow down overall US growth. A decline in rates or in the dollar acts as stimulus.

What is 2017 likely to bring?

interest rates

Ignoring the mid-year lows, one-month T-bills began 2016 at a 0.17% yield and are now at 0.39%. The 10-year bond opened the year yielding 2.24% and is closing at 2.46%. Over the same period, the Federal Reserve has raised the overnight money rate by 0.25%.

My guess is that the Fed will raise the overnight lending rate by at least 0.50% and possibly by 0.75% in 2017. The latter would likely translate into a rise in the 10-year to something just below 3%, the former to a yield of 2.75% or so.

currency

I think the chances of the larger rate rise are greater if the dollar remains around today’s level. As I’ve written recently, I think the US stock market is already trading as if long-dated Treasury bonds were yielding 4%–where I think the endpoint of restoring rates to normal will be. That’s something that probably won’t occur until 2018.

In addition, the US stock market has typically gone sideways during past times of Fed tightening. What would be unusual this time around would be if Congress follows through on a large, growth-stimulating, public works spending program. This would, I think, minimize any negative effect rising rates would have on stocks.

effects on the S&P 500

If the past is prologue, the main effect of rising rates and rising currency will be on the relative performance of sectors.

The more interest rates rise, the more attractive bonds will become vs.stocks whose main appeal is their stream of dividend income. So income stocks would be negatively affected.

The more the US$ rises, the weaker the US$ growth of foreign operations of US multinationals will be. Import-competing businesses would be hurt as well. Purely domestic firms would be relatively unaffected. My guess, however, is that the bulk of the dollar rise on a more functional national government has already occurred.

Early indicators after the UK vote to “Leave” the EU are already showing the country is dipping into recession. Nevertheless, large-cap stocks in the UK have held up surprisingly well.

This can clearly be seen in the results just announced yesterday by IHG. The fear of markets before Brexit about hotels had been that the post-recession cyclical upsurge in vacationing had just about run its course–and that, as a result, hotel profits were just about to peak/had already peaked. But the figures from IHG were good and the stock rose by about 3% on the news.

To see how this can be, it’s important to note that the post-Brexit decline in the fortunes of the UK has been expressed almost entirely in a 10%+ decline in the British currency. This is an unexpected boon for British-based multinationals.

At 30 June 2016 exchange rates, approximately 70% of our debt is denominated in sterling.”

All of these figures are now 10% less in purchasing power terms than they were pre-Brexit. Without any price changes, revenues will be 0.5% lower in dollar terms than they would have been. But overheads will be down by much more. In addition, the dollar value of the company’s debt is sliced by about $128 million.

This situation has two positive effects in the minds of UK investors:

–profits will likely be higher than anticipated, making the stock more attractive, and

–to the extent that a company like IHG, which has the lion’s share of revenues outside the UK, is affected by Brexit, the influence is likely to be positive. This means that it can act as a way for British residents to preserve the purchasing power of their savings.

I started to learn about the UK stock market in 1986, a scarily long time ago, when I took over management of a failing global fund. I realized pretty quickly, though, that despite similarity with the US in language and accounting standards, London stocks trade on complex signals that are far different in kind from those I was familiar with in New York. I ultimately decided that the large effort required to become proficient would pay too small a reward to justify making it. So I remain more or less an innocent (read: the dumb money) in that market to this day.

12% cheaper

Nevertheless, the large drop (about 12%) in the value of the pound against the dollar suggests to me that there will ultimately be a big post-Leave-vote equity investing opportunity in the UK. If the government follows through on its plans to cut the corporate tax rate from the current 20% to 15% (something the EU would have opposed) and lowers interest rates as well, the potential would be substantially larger.

Two reasons:

Mexico

–Weak currencies most often mean strong stock markets. The most striking example I can think of is Mexico in the 1980s. Over that period, the peso lost 98% of its value against the US$. Still, Mexican stocks were, in US$ terms, just about the best-performing in the world–outdoing the US stock market by a mile.

Three causes: supportive economic policies by the Mexican government; currency decline gave Mexican exporters a powerful price advantage; and the currency collapse created substantial inflation, which prompted local investors to strongly prefer equities as a way of preserving the real value of their savings.

Yes, Mexico is an extreme, but stocks in the UK are now 12% cheaper in US dollars than they were a couple of weeks ago. And the government appears to be preparing to implement significant economic stimulus. So earnings prospects for many firms are substantially better.

currency markets lead the way

–currency fall typically comes in advance of stock market rise. The lag may be months. This is partly because the currency markets always seem to act far ahead of stocks and bonds. It’s also because equity investors, particularly in Europe, want to see some evidence of earnings improvement–either actual results or management confirmation that the numbers are looking surprisingly good–before they are willing to act.

timing

The big question, I think, is not whether London stocks, especially multinationals or exporters, will do well. It’s when the fallout from the Brexit vote will have fully played itself out in financial markets. Given that European investors typically take the month of August off, and that the start of this annual vacation period is only a few weeks away, my guess is that this won’t be until close to Labor Day.